What is moral hazard?

“Moral hazard” is a term used in the insurance industry to describe situations in which people may be inclined to take greater risks if they are insured than if they are uninsured. It occurs when someone has limited liability for the risks they take and the costs they create.

Learn when moral hazard comes into play, how it works, and how it is used to assess insurance risk.

Definition and examples of moral hazard

For insurance companies, the concept of moral hazard means that policyholders may take risks that they would not otherwise take if they were held solely responsible for the outcome. Most people don’t intend to take advantage of an insurance company, but if you realize that your risks are limited, moral hazard might creep into your mental calculations.

Risk and reward usually go hand in hand. If you take a risk, you pay the price when things go wrong and you can get away with it if the risk pays off. But when “moral hazard” is involved, things work differently.

For example, an insured person or organization may have an incentive to take more risks than they otherwise would, because they do not have to pay for them. If they take a risk and it goes well, they win. If things go wrong, but someone else pays the price, the consequences of taking the risk are minimal.

How moral hazard works

When moral hazard arises, one person or entity has the opportunity to take advantage of the other. They may take unexpected risks or incur costs that they won’t have to pay, no matter what happens next. The concept applies to all types of insurance.

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For example, an insurance company may sell an automobile insurance policy to a customer. In this case, the insurer is liable for damage to the vehicle – or caused by the vehicle – and the customer pays the insurance premiums for this protection.

The customer may realize that there is less risk in driving recklessly if the insurance company pays (almost) everything. For example, the customer may be driving at high speed on slippery roads knowing that the insurance company is likely to pay for any potential damage to the vehicle. Even if the customer skids on the road and destroys a fence, the insurance company may still be liable for payment.

The customer may have to pay a deductible and live without a vehicle while repairs are completed, and there may be civil or criminal charges for reckless behavior. Yet with a comprehensive policy, the financial cost can be relatively low.

What this means for insurance companies

With insurance, moral hazard can cause people to take greater risks or incur greater costs than they otherwise would. In a situation where moral hazard is present, there is usually a mismatch between the amounts of information each party has about the risks involved.

Continuing the example above, the insurance company can reasonably assume that drivers generally want to avoid accidents. Insurance companies use statistics to get an idea of ​​the level of risk present in the general population, but they cannot know what is going through the minds of every customer. Drivers want to get to their destination safely, but some people may be tempted by the potential benefits of taking excessive risks.

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Moral hazard can also be a factor in life insurance. When a person believes they are likely to die, they may be motivated to purchase insurance. This belief can stem from knowledge of health problems or suicidal ideation, and insurance companies have several strategies to reduce risk. To manage their exposure to risk, insurers often conduct a thorough review of an applicant’s medical history, occupation and potentially risky hobbies, and they may even require a medical examination. They also might not pay a death benefit if the insured dies by suicide within two years of the policy issue date.

If you are having suicidal thoughts, contact the National Suicide Prevention Lifeline at 800-273-8255 for support and assistance from a trained counselor. If you or a loved one are in immediate danger, call 911.

Adverse selection

Moral hazard is related to “adverse selection,” or the tendency of people with higher levels of risk to purchase more generous insurance coverage. When people think they are at risk of incurring a loss, they may prefer that another entity, such as an insurance company, pay for the costs. Someone who thinks they are in good health may opt for a no-frills health insurance plan, while people with health issues may want more robust coverage.

Adverse selection affects your decisions about whether to buy coverage (and how much to buy). Moral hazard affects decision making after you have insurance coverage in place.

Notable events

Moral hazard exists in several areas beyond insurance. Whenever a person can take a risk that others can afford, moral hazard is a factor. For example, this phenomenon may have contributed to the mortgage crisis that peaked in 2007 and 2008.

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Before the crisis, lenders were eager to make a profit from making loans, but they often sold these loans to investors. Without “skin in the game,” they had little incentive to manage risk and ensure borrowers could repay their loans. As a result, lenders did not always verify that borrowers had sufficient income and assets to qualify for large mortgages. By selling these loans, lenders could dodge the consequences should borrowers later default on their mortgages.

Key points to remember

  • Moral hazard involves one party taking risks that others will have to pay for.
  • Those paying the costs often lack complete information about who is taking the risks.
  • Moral hazard can exist in various fields, including insurance, loans, investments, etc.


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